Are State And Local Government Pensions Underfunded By $5 Trillion?

Andrew Biggs
, ContributorI work on retirement policy, public sector pay and other issues.Opinions expressed by Forbes Contributors are their own.

If the Actuarial Standards Board enacts recommendations from its Pension Task Force, actuarial valuations for state and local government pensions will report unfunded liabilities of over $5 trillion and funding ratios of just 39 percent. The public pensions industry will hate it, but those figures are the best available measures of the costs of public employee retirement plans.

A Pension Task Force established by the Actuarial Standards Board (ASB) has recommended rules changes that would require all pension actuaries to calculate and disclose the “market value” of retirement plan liabilities, a step that has been fought hard by the public pensions industry. Proponents of market-value liability figures, which include most economists as well as many policy analysts concerned about pension funding, argue that current actuarial methods understate pensions’ true benefit liabilities and encourage pensions to take excessive investment risk. While the ultimate decision on actuarial standards lies with the Actuarial Standards Board, it would be difficult for the ASB to reject the recommendations of its own task force on such an important issue. So this could mean a big change in how we view state and local government employee pension funding.

Under current practice, a state or local government employee retirement plan “discounts” its benefit liabilities using the assumed return on the investments held by the plan. At first glance, this makes sense: if we discount liabilities using the assumed return on investments and we make contributions based on that discounted value, then – assuming the plan’s future investment returns are equal to the assumptions made today – the plan should be able to pay all the benefits it owes. Most state and local pensions hold about 75 percent of their investments in risky assets such as stocks, private equity or hedge funds and they assume annual investment returns of about 7.6 percent. Based on this methods, state and local plans today are about 74 percent funded and have unfunded liabilities of about $1.4 trillion.

But here’s a fact that should tell you something: almost no other pension plans in the world are allowed to use the kind of accounting that U.S. state and local plans can. Corporate pension plans can’t discount their liabilities using the assumed return on investment. Nor can most public employee pensions in other countries.

Here’s why: defined benefit pensions promise a benefit that’s guaranteed. Legally it’s very hard to cut benefits that have already been earned and in the public sector it’s tough even to reduce the rate at which employee earn future benefits. Many state constitutions guarantees benefits, as reformers in Illinois, Oregon and elsewhere have discovered.

What this means is that if a pension plan’s investments don’t meet up to their assumed returns – and there’s a very good chance this won’t happen – then the taxpayer has to step in to make up the difference. The average “required contribution” for public pensions more than tripled from 2001 to 2013, mostly because investment returns have been sub-par.

So the true liability for taxpayers isn’t merely the obligation to make contributions on the assumption that those contributions will earn 7.6 percent returns. It’s to make whatever contributions are necessary to pay benefits, regardless of how the plan’s investments might fare. The way to measure that kind of liability is to discount the plan’s future benefit payments using the interest rate from a guaranteed investment like U.S. Treasury bonds. As of mid-2015 – when figures were last produced for state and local pensions – the average yield on Treasuries with durations of between 10 and 20 years was about 2.6 percent. (The logic behind using a risk-adjusted discount rate isn’t always intuitive; here’s an effort to make it slightly more understandable.) U.S. corporate pensions must discount their liabilities using a corporate bond yield, which conveys that corporate pension payments carry about the same risk of default as corporate bonds. Overseas pensions usually discount using some variation on a government bond yield.

This “market valuation” approach tells us several interesting and useful things.

First, it shows that state and local pensions aren’t nearly as well-funded as you’d think. Let’s assume that we valued public pension liabilities using the 2.6 percent average of 10- and 20-year Treasury yields. Instead of state and local plans being 74 percent funded with $1.4 trillion in unfunded liabilities, as they state using a 7.6 percent discount rate, using the Treasury yield these plans are about 39 percent funded with unfunded liabilities of about $5.2 trillion. That $5.2 trillion is the number most economists would think is most relevant to considering the costs of public sector pensions. For context, the total national debt including the Social Security and Medicare trust funds is about $19 trillion, so for state and local governments to face shortfalls one-quarter that size just for their employee pension programs is worrying.